Market Savior? Stocks Might Be 50% Lower Without Fed

A report from the Federal Reserve Bank of New York suggests that the bulk of equity returns for more than a decade are due to actions by the US central bank.

AP

NYSE Traders

Theoretically, the S&P 500 would be more than 50 percent lower—at the 600 level—if the bullish price action preceding Fed announcements was excluded, the study showed.

Posted on the New York Fed’s web site Wednesday, the study sought out to explain why equities receive such a high premium over less risky assets such as bonds.

What they found was that the Federal Reservehas had an outsized impact on equities relative to other asset classes.

For example, the market has a tendency to rise in the 24-hour period before the release of the Fed’s statement on interest rates and the economy, presumably on expectations Chairman Ben Bernanke and his predecessor, Alan Greenspan, would discuss or implement a stimulus measure to lift asset prices.

The FOMC has released eight announcements a year at 2:15 ET since 1994. The study took the gains in the S&P 500 from 2 pm the day before the announcement to 2 pm the day of the statement and subtracted that market move from the S&P 500’s total return over that time span.

Without the gains in anticipation of a positive Fed action, the S&P 500 would stand at just 600 today, rather than above 1300.

“I would conclude that correctly analyzing Fed moves is much more important than stock picking,” said Brian Kelly of Shelter Harbor Capital. “If you want to generate alpha, you should trade the stock market 24 hours before an FOMC meeting. Simply follow the trend for that 24 hours and you will outperform.”

The chart shows the effect to be significantly pronounced in the aftermath of the tech bubble when Greenspan re-inflated stock and housing prices by slashing rates. It widens even further in the period since the financial crisis of 2008 as the market became beholden to the Fed’s use of its balance sheet to add liquidity to the market.

“Blame Greenspan for this S&P 500 effect… it’s his free put,” said Robert Savage, chief executive of research site Track.com and formerly managing director of FX Macro Sales at Goldman Sachs. “Since 1994, the battle of central banks hasn't been to fight inflation, but rather to smooth out the business cycle and credit. The convergence of global rates and inflation left the decisions of the FOMC as the key variable for S&P 500.”

The market is down six days in a row currently on the concern that the Federal Reserve will not embark on its third round of so-called quantitative easinganytime soon. Minutes from the central bank’slast meeting, released Wednesday, reinforced the concern that the economy is muddling along enough to keep the Fed on the sidelines.

To be sure, one cannot look at these Fed actions in a vacuum and conclude the S&P 500 would plummet 50 percent if the Fed were to undue all of its supportive measures of the last two decades. But that doesn’t mean this exercise can’t be instructive.

For example, proponents of index funds will often argue their case by using data that shows a significant drop in S&P 500’s yearly returns if you took out the five best days of that particular year. The point: you need to always be fully invested so you don’t miss one of those days, which account for the majority of the market’s annual return.

The Fed’s next announcement is due August 1st and it would seem by this study, one would want to make sure they are invested in the market by 2pm on July 31st,

“It's a QE world,” said Josh Brown, an investment advisor and popular author of The Reformed Broker blog. “We're all just trading in it.”

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